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Tuesday, January 22, 2008

Digesting the Rate Cut

As most have probably heard, the Fed has cut interest rates this morning. Most of the investment markets weren't impressed and they continued to drop. The treasuries responded favorably and the ten year is fast approaching record levels that most mortgage brokers thought would never be seen again after 2003.

It is clear the Fed sees serious problems for the economy on the horizon. I continue to be confused by the panicked state. While jobs have weakened tremendously we continue to create jobs and the unemployment rate continues to be 5%. We still have strong GDP growth and the stock market, despite its drops, is still near record highs. When this is combined with severely weak dollar and outrageously high oil prices, there is still plenty of concern that should be had at inflation. Such drastic rate cuts can have a boomerang effect and create a period of high inflation when the Fed is trying to stop a recession.

The Federal Funds rate is now at 3.5%. That is fairly low though there is no doubt that the Fed could move to drop it even further. I think that Greenspan set a dangerous precedent by dropping it to .75% in 2002-2003, and the Fed could be looking at the as guidance. We could still see major fiscal expansionary policy that will be combined with this monetary policy.

The problem I have with all of this aggressive action is that it is a response to emotion: the emotion of markets in panic, the emotion of the media painting a gloomy picture, and the emotion that the housing crisis naturally brings. Emotions are usually not a very good indicator of economic reality. The reason that the Fed chair is selected not elected is exactly so that individual doesn't respond to emotion.

The facts are these. The Fed has cut interest rates by 1.75% at a time when GDP growth is 3.6%, unemployment is 5%, the stock market is near all time highs, dollar at all time lows, and oil at all time highs. If that doesn't give pause to anyone worried about inflation, I don't know what does.

Keep in mind that in an election year every politician will jump over each other to be see as being proactive against the recession that technically hasn't even started yet. The last GDP numbers were strong and if anything too strong. Thus, it is quite possible that the Fed is heating up a market that is plenty hot on its own.

The lesson of Greenspan's irresponsible rate cut is loose money leads to irresponsible lending. The Fed is again dangerously close to creating another environment of loose money. The banks have learned their lessons with mortgages, and thus they may very well begin irresponsibly lending on small business loans, car loans, or even personal loans. This rate cut will likely stimulate banks to act. They will likely act and hopefully they won't act irresponsibly, however I fear they will.

1 comment:

Anonymous said...

Thought you might find theses articles interesting.

Bernanke is 9 months behind the curve because he was worried about inflation and misjudged the real problems within the financial system. I am hoping he has seen the "light", another 50bspt drop next week will confirm that he has. imho
I wouldn't be surprised to see a 1% GDP in the first quarter, and the price of oil continue to decline as the economy slows temporarily. Timb